Struggling to Keep Up as the Crisis Raced On

“I feel like Butch Cassidy and the Sundance Kid. Who are these guys that just keep coming?” — Treasury Secretary Henry Paulson Jr.

It was the weekend of Sept. 13, and the moment Treasury Secretary Henry M. Paulson Jr. had feared for months was finally upon him: Lehman Brothers was hurtling toward bankruptcy — fast.

Knowing that Lehman had billions of dollars in bad investments on its books, Mr. Paulson had long urged Lehman’s chief executive, Richard S. Fuld Jr., to find a solution for his firm’s problems. “He was asked to aggressively look for a buyer,” Mr. Paulson recalled in an interview.

But Lehman could not — despite what Mr. Paulson described as personal pleas to other firms to buy some of Lehman’s toxic assets and efforts to persuade another bank to acquire Lehman. With all options closed, he said, the government’s hands were tied. Although the Federal Reserve had helped bail out Bear Stearns — and was within days of bailing out the giant insurer American International Group — it could not help Lehman, even as its default threatened to wreak havoc on financial markets.

“We didn’t have the powers,” Mr. Paulson insisted, explaining a decision that many have since criticized — to allow Lehman to go bankrupt. By law, he continued, the Federal Reserve could bail out Lehman with a loan only if the bank had enough good assets to serve as collateral, which it did not.

But that is not the way that many who have scrutinized his actions see it. Bankers involved say they do not recall Mr. Paulson talking about Lehman’s impaired collateral. And they said that buyers walked away for one reason: because they could not get the same kind of government backing that facilitated the Bear Stearns deal. In retrospect, they added, it was emblematic of the miscalculations by the government in reacting to the crisis.

The day after Lehman collapsed, the Fed saved A.I.G. with an emergency $85 billion loan, but the credit markets around the world began freezing up anyway. It was at this point that Mr. Paulson — feeling outgunned by pursuers, like Butch and Sundance — decided he had to find a systemic solution and stop lurching from crisis to crisis, fixing one company’s problems only to find several more right behind.

In nearly a century, no Treasury secretary has faced a more difficult financial crisis than that Mr. Paulson is contending with. For months, he and his team have been working around the clock, often seven days a week, trying — in vain — to keep it from deepening. In an hourlong interview with The New York Times, Mr. Paulson defended Treasury’s actions, saying that he and his aides had done everything they could, given the deep-rooted problems of financial excess that had built up over the past decade.

“I could have seen the subprime problem coming earlier,” he acknowledged in the interview, quickly adding in his own defense, “but I’m not saying I would have done anything differently.”

History will be the final judge. But in contrast with Mr. Paulson’s perspective, other government officials and financial executives suggest that Treasury’s epic rescue efforts have evolved as chaotically as the crisis itself. Especially in the past month, as the financial system teetered on the abyss, questions have been raised about the government’s — and Mr. Paulson’s — decisions. Executives on Wall Street and officials in European financial capitals have criticized Mr. Paulson and Mr. Bernanke for allowing Lehman to fail, an event that sent shock waves through the banking system, turning a financial tremor into a tsunami.

“For the equilibrium of the world financial system, this was a genuine error,” Christine Lagarde, France’s finance minister, said recently. Frederic Oudea, chief executive of Société Générale, one of France’s biggest banks, called the failure of Lehman “a trigger” for events leading to the global crash. Willem Sels, a credit strategist with Dresdner Kleinwort, said that “it is the clear that when Lehman defaulted, that is the date your money markets freaked out. It is difficult to not find a causal relationship.”

In addition, Mr. Paulson and Mr. Bernanke have been criticized for squandering precious time and political capital with their original $700 billion bailout plan, which they presented to Congressional leaders days after the Lehman bankruptcy. The two men sold the plan as a vehicle for purchasing toxic mortgage-backed securities from banks and others.

But even after the House finally passed the bill on Oct. 3, markets remained in turmoil. It was not until Britain and other European countries moved to put capital directly into their banks, and the United States followed their lead, that some calm returned.

Photo

In nearly a century, no Treasury secretary has faced a more difficult financial crisis than the one Henry M. Paulson Jr. is contending with.Credit
Todd Heisler/The New York Times

In the interview, Mr. Paulson said that even before the House acted, he had directed his staff to start drawing up a plan for using some of the $700 billion to recapitalize the banking system — something that Congress was never told and that he had publicly opposed.

Why? Because in the week before the plan passed Congress, conditions deteriorated significantly, Mr. Paulson said.

But many complain the worst of the turmoil might have been avoided if it hadn’t been for Mr. Paulson sticking with an original bailout plan that they viewed as poorly conceived and unworkable. “They were asking the most basic questions,” said one Wall Street executive who spoke to Treasury officials after the bailout bill was passed. “It was clear they hadn’t thought it through.” Senator Charles E. Schumer, Democrat of New York, who had called for an infusion of capital into banks in mid-September, said, “They are so much more on top of this recapitalization plan than they were about the auction plan.”

Even as he defended his actions, Mr. Paulson said he was worried that some of the government’s moves could wind up haunting future Treasury secretaries. He pointed in particular to the decision to guarantee all bank deposits and interbank loans, something the United States did to keep pace with similar decisions in Europe. “We had to,” Mr. Paulson said. “Our banks would not have been able to compete.”

But the federal guarantees could create “moral hazard” and simply encourage banks to take on dangerous risk, he acknowledged. “This is the last thing I wanted to do,” he said.

The subprime mortgage debacle began emerging in the summer of 2007, about a year after Mr. Paulson left his job as head of Goldman Sachs and joined the Bush administration. But the true depth and extent of the losses did not become clear until earlier this year, Mr. Paulson said.

“We thought there was a reasonable chance of getting through this,” he recalled.

Then came the near failure in March of Bear Stearns, which was rescued in a takeover by JPMorgan Chase only after the Fed agreed to cover $29 billion in losses. That briefly lulled the markets into thinking the worst might be over. But during the summer, conditions deteriorated, and in early September the government was forced to take over Fannie Mae and Freddie Mac, the mortgage finance giants.

With increasing speed, other problems emerged, most notably Lehman and A.I.G., which was also burdened with bad mortgage-related investments. Both became the focus of intense meetings the weekend of Sept. 13-14.

Mr. Paulson, by then, had become frustrated with what he perceived as Mr. Fuld’s foot-dragging. “Lehman announced bad earnings around the middle of June, and we told Fuld that if he didn’t have a solution by the time he announced his third-quarter earnings, there would be a serious problem,” Mr. Paulson said. “We pressed him to get a buyer.”

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Here the views of Mr. Paulson and his critics start to diverge, over what transpired in marathon meetings with Wall Street executives at the Federal Reserve Bank of New York that weekend.

Lehman officials said they believed the firm had not one but two potential buyers: Bank of America and Barclays, the big British bank. But both had conditions. Bank of America wanted the Fed to make a $65 billion loan to cover any exposure to Lehman’s bad assets, according to one person privy to the discussions who did not want to be identified because of their sensitive nature. Although this was more than double what the Fed had made available to facilitate the takeover of Bear Stearns by JPMorgan, Bank of America justified the request on the grounds that Lehman was larger.

Barclays also wanted a guarantee to protect against losses should Lehman’s business worsen before Barclays could compete its takeover.

The government initially was not clear in telling Bank of America and Barclays that no help would be forthcoming, participants said. The New York Fed president, Timothy F. Geithner, in particular, was uncomfortable about drawing a line in the sand against government support for a Lehman takeover. Participants said they were left with the impression from Mr. Paulson and Mr. Geithner that the government might well provide help for a serious buyer, with Mr. Paulson also trying to get Wall Street firms to create a $10 billion fund to absorb some of Lehman’s bad assets.

It remains unclear whether a more consistent message would have changed the outcome. But by Saturday, Bank of America, frustrated by the government’s unwillingness to commit to a deal, turned its attention to Merrill Lynch, which agreed to a takeover. Barclays, equally frustrated, walked away on Sunday, said the person with knowledge of the discussions.

Mr. Paulson said in the interview that Treasury was not at fault. The $10 billion industry fund had not worked because executives in the room realized that bailing out Lehman would not end the crisis. There were too many other firms that needed help. “I didn’t want to see Lehman go,” Mr. Paulson said. “I understood the consequences better than anybody.”

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Henry Paulson said the risk of the credit crisis became clear only this year. Before, he said, we thought there was a reasonable chance of getting through this.Credit
Todd Heisler/The New York Times

At a White House briefing on Sept. 15, Mr. Paulson shed no tears over Lehman’s failure. “I never once considered it appropriate to put taxpayer money on the line in resolving Lehman Brothers,” he told reporters.

In the interview, however, Mr. Paulson said the main issue was whether it was legal. Under the law, the Fed has the authority to lend to any nonbank, but only if the loan is “secured to the satisfaction of the Federal Reserve bank.” When pressed about why it was legal for the Fed to lend billions of dollars to Bear Stearns and A.I.G. but not Lehman Brothers, Mr. Paulson emphasized that Lehman’s bad assets created “a huge hole” on its balance sheet. By contrast, he said, Bear Stearns and A.I.G. had more trustworthy collateral.

People close to Lehman, however, say it was never told this by the government. “The Fed and the S.E.C. had their people on site at Lehman during 2008,” said a person in the Lehman camp. “The government saw everything in real time involving Lehman’s liquidity, funding, capital, risk management and marks — and never expressed any concerns about collateral or a hole in the balance sheet.”

The aftermath of the Lehman bankruptcy was disastrous. “Lehman was one of the single largest issuers of commercial paper in the world,” said Joshua Rosner, a managing director at Graham Fisher & Company, referring to short-term debt issued by companies to finance day-to-day operations; this market locked up in the wake of Lehman’s failure. “How could you let it go bankrupt and not expect the commercial paper market to be completely crushed?” Why Bear Stearns but not Lehman, wonders Representative Barney Frank. Mr. Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, has generally been a supporter of Mr. Paulson during the crisis. “If it was the right thing to do, why did they do it only once?” he asked.

In response, Mr. Paulson said that only now that the bailout bill has been passed does the government have the authority to intervene in a nonbank failure in cases of firms that lack adequate collateral, like Lehman.

A Difficult Sell

Lehman’s failure was followed by another strategic misstep by Treasury, critics say. They assert that Mr. Paulson initially pushed the wrong systemic fix: a bailout plan that revolved around buying up toxic securities, rather than putting capital into the banking system, a far more direct way of providing assistance.

Mr. Paulson rejects this view. In the interview, he cited several reasons he and Mr. Bernanke concentrated initially on purchasing distressed assets. First, he said, this plan had been in the works for months and was much further developed. “If we had felt going in that the right way to deal with the problem was to put equity in, we would have taken some time and developed a program,” he said.

He also worried that Congress would not be receptive to the idea of Treasury taking an ownership stake in banks: “This is a very complicated and difficult sell. We want to put equity in, but we don’t want to nationalize the banks. And I don’t know how to sell that.”

But he doesn’t dispute that he changed direction. Mr. Paulson said that by Oct. 2, as he was departing for a weekend getaway to an island with his family — his first weekend off in nearly two months — he told his staff, “We are going to put capital into banks first.”

Although the bailout bill still had not passed, the financial markets had deteriorated. He did not, however, inform Congress of his change of heart, and the House debate revolved almost entirely around the asset-purchase plan.

Just 11 days later, Treasury had come up with a plan to inject capital into the banks — which Mr. Paulson sold to the nation’s nine largest financial institutions on Oct. 13. “I can imagine being dinged for some things,” he said, “but not for moving that quickly.”

He also defended Treasury’s recapitalization plan against critics who say that he did not extract a high enough price from the banks getting taxpayers’ money. “I could not see the United States doing things like putting in capital on a punitive basis that hurts investors. And we don’t want to run banks.”

The Global Extent

Asked what he might have done better, Mr. Paulson replied, “I could have made a better case to the public.”

He added, “I never felt worse than when the House voted no” on the bailout plan Sept. 26, its initial rejection before ultimately passing the plan.

As for Lehman, Mr. Paulson insisted that it was “a symptom and not a cause” of the financial meltdown that took place in recent weeks. The real problem, he contended, is that banks all over the world made wrong-headed loans that have now come back to haunt them. After meeting recently with European central bankers, he said, “the thing that took your breath away was the extent of the problem. Look at country after country that said they didn’t have a problem, and it turned out they had a huge problem.”

Mr. Paulson added, “No one will, 10 years from now, write the story that this crisis was about Lehman Brothers going down.”

Nelson D. Schwartz and Stephen Labaton contributed reporting.

A version of this article appears in print on , on Page A1 of the New York edition with the headline: Running a Step Behind as a Crisis Raged. Order Reprints|Today's Paper|Subscribe